Contagious Defaults?

Mohamed El-Erian, CEO of PIMCO, the world’s largest bond investment management group, recently made a compelling plea for “urgent EU action” to stop a contagious financial crisis from sweeping the Eurozone. While it is true that the sell-off of Irish bonds over the past weeks has pushed default spreads higher on other troubled European member states, we can hardly say that such an event is contagion driven.

With Euro area and IMF loans keeping Greece on life support, investors turned their attention to the next European domino to fall. Crisis, or some semblance of it, has been averted in Ireland (at least for now). No sooner was it saved than investors turned their attention to the next potentially distressed debtor. Portugal. Spain. Italy. Rumors are circulating of Belgium, or even France soon needing EU aid.

While it is tempting to treat these countries as innocent bystanders afflicted with a pesky contagious disease nothing could be more misleading.

No less an authority than Anna Schwartz informs us that: “Contagion, if the term is used accurately, occurs only in circumstances in which other countries are free of the problems of the country that first experienced trouble and yet suffered unwarranted investor disaffection.” Not a single country in the Eurozone seems to fit this description – not even the most prudent (Germany) or the most diminutive (Malta).

The disease afflicting Europe today has been brought on by years of money mismanagement. An inflationary policy directed by the ECB in Frankfurt spread throughout the countries using the euro. As the ECB pursued a loose monetary policy, high inflation countries – the PIIGS of today – saw real interest rates drop to the lowest levels in a generation. It is no surprise that the housing boom was most pronounced in exactly those countries with the highest inflation rates during the boom years – Spain and Ireland.

A centrally directed monetary policy set in Frankfurt by the ECB had its effects asymmetrically felt across Europe. While the ECB directed its key refinancing rate for all Eurozone borrowing from it, real interest rates of its member states diverged wildly. High inflation periphery countries saw real interest rates turn down sharply, even veering into negative territory during much of the boom. The fractional reserve structure of the monetary system allowed a huge amount of credit to be built upon a relatively small amount of actual deposits, savings and bank reserves. With a reserve requirement set at 2 percent since 1999, the ECB permitted €50 to be loaned out as credit for every €1 a bank holds in its vaults. The Bank of England permitted even more extreme potential increases in credit. A voluntary reserve requirement is in force, implying that banks can loan out an infinite amount of credit against zero deposits. Such policies allowed a credit induced boom to sweep the Euro area, the repercussions of which are only now becoming fully known.

El-Erian, among other commentators, would do well to research the recession’s causes before claiming an EU bailout is necessary to stave off contagion. The current bout of “contagion” is nothing of the sort. A centralized monetary policy bred an unsustainable situation. After persisting for several years it is only now being corrected. Policy makers are well-advised to focus on the government-controlled and fractional reserve monetary system that caused the bust, instead of trying to absolve themselves of responsibility through a misused word.

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